Fixed Income: A New Smart Beta Frontier

As smart beta has become an increasingly important (and larger) part of the overall exchange traded funds (ETFs) landscape, ETF users, professional and retail alike, have openly wondered when the idea of alternative weighting would make its way to the fixed income space.

The discussion has merit. After all, today's smart beta universe, both in terms of assets under management and population, is dominated by equity funds. As more advisors and investors warm to smart equity funds, there is likely to be increased demand for alternatively-weighted bond funds. That makes sense as many traditional bond funds suffer from the same drawbacks as cap-weighted equity ETFs.

Those drawbacks include lack of diversity and a dependence on the biggest, not necessarily the best, securities as primary drivers of returns. For example, standard aggregate bond ETFs are usually excessively allocated to U.S. Treasuries and mortgage-backed securities (MBS), meaning lack of exposure to higher-yielding corporate and emerging markets debt.

Likewise, many legacy corporate bond ETFs weigh components by size of issue or value of the issue outstanding. Alternative weighting methodologies with corporate bonds can offer increased income and potentially lower risk.

Established Fare

While ETF users have been clamoring for more smart beta bond ETFs, the truth is this category actually has some legacy products. For example, the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) is over a decade old and with nearly $3.8 billion in assets under management, PCY is the largest emerging markets bond ETF.

PCY uses a proprietary index methodology to deliver exposure to developing world sovereign debt, giving the ETF a significantly different look at the country level relative to traditional emerging markets bond funds.

Then there is the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB), which tracks the RAFI Bonds US High Yield 1-10 Index. PHB is also over a decade old and has over $944 million in assets under management.

Still, in spite of the promise these funds show and as of 4Q 2018, just two bond ETFs had over $1 billion in assets.

Expect More

While the universe of smart beta bond ETFs is still sparsely populated, some big-name ETF issuers are looking to change that. BlackRock's iShares, Goldman Sachs and JPMorgan Asset Management are among the issuers that already have or are planning to expand into the world of smart beta bond ETFs.

“Technological advances may also have a significant impact on the growth of smart beta,” said FTSE Russell. “The increasing availability of data and developments in data science mean that smart beta indexes are likely to reflect a growing range of different approaches, across asset classes. Fixed income smart beta, in particular, is an area of interest for many market participants, since a standard approach of constructing indexes by the market value of the debt in issue may not reflect the user's risk preferences.”

Rules-based bond ETF can screen for and emphasize factors such as credit risk, interest rate risk and yield.

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